1031 Exchange

As a real estate investor, selling your property may be part of your strategy. However, heavy capital gains taxes can cut into your profits–you may incur taxes of 20-30% of the total sale price, especially if your property has appreciated significantly. A 1031 exchange, also known as a ‘like-kind exchange’, delays those capital gains taxes by sheltering the proceeds from the sale with a qualified intermediary for a short period while you find similar property or properties in which to reinvest.

A 1031 exchange grants you 45 days to find your next investment, and 180 days to close on your next property, all without incurring a tax bill. Using a 1031 exchange can offer an opportunity to diversify your portfolio, switch property types, and expand your real estate portfolio.

1031 exchanges can also be used in conjunction with other tax-advantaged products to help you diversify your portfolio. This strategy works well with a 721 exchange if you’re ready to transition to a more hands-off approach to real estate investing.

There are various risks associated with a 1031 exchange, such as, but not limited to: strict deadlines, timelines, and rules, difficulty finding suitable replacement properties, property valuation and market fluctuations. The 1031 exchange process is complex and requires the expertise of a qualified intermediary (QI) and potentially other advisors, such as a financial, real estate or tax attorney.

It’s crucial to consult with a tax and financial advisor and a reputable QI to ensure proper structuring and execution of a 1031 exchange and to help minimize the associated risks.

721 Exchange

If you’re ready to transition from landlord to passive investor, a 721 exchange can help you liquidate your property without a heavy tax burden. Also known as a UPREIT (Umbrella Partnership Real Estate Investment Trust), a 721 exchange offers the opportunity to transfer property to a REIT’s operating partnership in exchange for operating partnership (OP) units. After a holding period of 12 to 24 months, the investor can convert their OP units into shares of the REIT.

Compared to owning individual properties, a REIT offers the same potential for growth without the time and labor required for property management and associated liabilities, as well as liquidity and passive income. Using a 721 exchange can allow for a seamless transition, which, when done correctly, can avoid any capital gains assessment.

There are various risks associated with a 721 exchange such as, but not limited to: loss of control, conversion limitations and tax Implications, illiquidity, REIT shares can fluctuate with stock market conditions, interest rate changes, and economic downturns, impacting the overall investment value. It is important to carefully research and evaluate the REIT’s portfolio, management team, and fees. Before making any investment decision, consulting with a tax and financial advisor is crucial to help ensure the transaction aligns with your investment goals and financial situation.

From Active to Passive: The Growth Two-Step

The 1031 exchange and the 721 exchange can be a potent combo, especially for real estate investors ready to transition out of direct ownership. Using the 1031 exchange, investors can purchase more valuable properties by leveraging the entirety of their sale price without the burden of capital gains taxes. As an alternative, they can also use a 1031 to invest in a DST (Delaware Statutory Trust).

Once they have reached the pinnacle of what they are willing to risk, investors can use a 721 exchange to transition their physical properties or DST interests into REIT OP units and eventually shares, which seek to create a diversified portfolio with increased liquidity and reduced tax liabilities.

Delaware Statutory Trusts (DSTs)

A Delaware Statutory Trust (DST) leverages the power of group investing. This legal entity allows multiple investors to pool their resources and invest in real estate properties. While group investing isn’t necessarily novel, a DST is considered an interest in real estate, rather than a security. The trust holds the title to the property on behalf of the investors, all of whom have a fractional ownership interest, known as a beneficial interest.

A DST can be a valuable stepping stone to REIT investment, as the IRS views it as real estate and is therefore eligible for a 1031 exchange and subsequent 721 exchange. For passive investors who prefer not to engage in active property management, this offers an opportunity for growth with a lower tax burden.

There are various risks associated with a DST such as but not limited to: illiquidity, lack of control, and fees. The value of DST properties is still subject to market fluctuations and potential losses. DSTs must adhere to strict operational rules to maintain their tax status. It is highly recommended to consult with a qualified intermediary, financial advisor, and tax professional to determine if a DST is suitable for your individual circumstances and to navigate the complexities involved.

Qualified Opportunity Zones (QOZs)

The Tax Cuts and Jobs Act of 2017 created another opportunity for real estate investing–Qualified Opportunity Zones or QOZs. A QOZ is an economically distressed community as determined by the state and certified by the Treasury Department. There are zones in all 50 states, as well as Washington, D.C. and the U.S. territories. The U.S. Department of Housing and Urban Development maintains an interactive map and list of QOZs.  

For investors facing significant tax liability as a result of capital gains, QOZs present an opportunity. Investors can defer capital gains taxes if they reinvest their profits into a QOZ. If they hold their investments, they may qualify for complete tax exclusion on the appreciation of their QOZ properties.

QOZ properties are not without risk – although they carry the potential to benefit an underserved community, they may also come with significant issues. Investors should carefully consider the costs and potential outcomes before committing to a QOZ project.

Qualified Opportunity Funds (QOF)

Investments in QOZs start with investing in a Qualified Opportunity Fund (QOF). These funds are organized as a corporation or partnership to invest in a QOZ. QOFs must include at least 90% of the fund value invested in QOZ properties, such as residential and commercial properties, and they must demonstrate their commitment to improving the properties through investment. The IRS requires any QOF to invest double the purchase price in the properties held within 30 months. 

While there is potential for significant growth in QOZs, like any investment, there is no guarantee of a positive return. Returns on QOZs may take several years; investors may not see cash flow until improvements are complete and the properties are rented out or sold. For the right investor, QOZs offer an opportunity to improve living conditions in their area while reducing their tax burden.

There are various risks associated with QOF such as but not limited to: illiquidity risk, geographic concentration risk, performance risk, management risk, development risks, economic risks, tax risks, IRS and regulatory risk, and high costs. QOFs are typically only available to accredited investors, who meet specific income or net worth requirements. It is essential to conduct thorough due diligence, understand the specific risks associated with each QOF, and consult with a qualified financial and tax advisor to determine if QOFs align with your investment goals and risk tolerance.

General risks associated with real estate investing can include fluctuations in the value of the underlying properties; defaults by borrowers or tenants; market saturation; changes in general and local economic conditions; decreases in market rates for rent; increases in competition, property taxes, capital expenditures, or operating expenses; and other economic, political or regulatory occurrences affecting the real estate industry.

 Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.